Kim: ‘Buy the dip’ but beware of tax pitfalls as year ends

Bespoke Investment Group reported at the end of September, “the Fed’s crusade against inflation resulted in a record destruction of wealth in dollar terms and an extremely large drawdown in percentage terms.” The “bear market” erased almost $13 trillion in market value from stocks. Supposedly “safe” investment-grade bonds shed almost $3 trillion, a record in both dollars and percentage. Cumulatively, the total drawdown in market value of the stock and bond markets came in just shy of $16 trillion, or just over 20%.

Absent a bodacious post-midterm election bounce and/or late-year “Santa Claus” rally, stock and bond mutual funds seem likely to end 2022 in deeply negative territory. Adding salt to that wound, despite these losses, most funds will also be making year-end distributions of realized capital gains, which are taxable on fund shares not held in retirement accounts (like 401(k)s or IRAs).

Like any investment owned in a taxable account, if you sell your mutual fund shares at a profit, you’ll owe capital-gains taxes on the difference between the “proceeds” (i.e. the dollar amount you received) and the “cost basis” (i.e. the amount you paid).

However, taxable mutual fund investors can also incur capital gains taxes even if they don’t sell a single share. Because U.S. mutual funds don’t pay taxes and are thus required to “distribute” realized capital gains and income to shareholders at least annually, unwary investors who are considering buying shares in a taxable account could face an unpleasant surprise.

Funds sell securities for a number of reasons. Besides sales done for normal portfolio management reasons, a fund might need to sell holdings to raise cash to pay departing shareholders. Similarly, a new portfolio manager might sell holdings to reconfigure the portfolio to her liking. Regardless of the reason, the fund realizes a capital gain or loss on each sale, based on the difference between the proceeds and cost. If the security was held more than a year, the realized capital gain or loss is considered long-term. Less than a year is considered short-term.

At least annually, mutual funds tally their realized gains and losses. If there is a net gain, that amount is “distributed” to shareholders. These distributions typically occur in December. If there is a net loss, that amount is “carried forward” and used to offset gains in future years.

A fund calculates its capital-gains distribution by dividing the total dollar amount of net gain by the number of shares outstanding on the “record date.” Assume Fund XYZ has assets of $100 million, 5 million shares outstanding on the record date of Dec. 15, 2022, and a net capital gain of $20 million. Fund XYZ has a net asset value (NAV) of $20 per share ($100 million of assets divided by 5 million shares) and will distribute $4 per share in capital gains ($20 million net gain divided by 5 million shares) on the “ex-dividend” date of Dec. 16, 2022.

The distribution automatically and immediately causes Fund XYZ’s NAV to drop (don’t worry!) by the same $4 per share to $16 per share ($100 million assets minus $20 million capital gains distributed equals $80 million, divided by 5 million shares).

Shareholders can elect to receive the distribution in cash or reinvest the amount in additional shares of Fund XYZ (at the new $16 NAV); either way, you owe the tax. So, if a shareholder owns 5,000 shares worth $100,000 (5,000 shares times $20 NAV) on the record date, she can either take a check for $20,000 ($4 per share distribution, reducing the value of her investment to 5,000 shares times $16 NAV, or $80,000) or reinvest the $20,000 in 1,250 additional shares ($20,000 divided by $16 NAV equals 1,250 shares), leaving the value of her investment constant (6,250 shares times $16 NAV equals $100,000). Reinvesting the distribution also increases her cost basis by $20,000, which will reduce the realized capital gain when she eventually sells the shares.

Here’s where it gets tricky for taxable shareholders: In this example, you receive the same $4 per-share distribution whether you owned the shares of Fund XYZ one day or 10 years on Dec. 15, 2022 (i.e. the record date). While the distribution is a non-event from an investment point of view, it can be a very big deal for taxes. Because of this, taxable shareholders should think twice about buying shares of a fund ahead of a large distribution (greater than 10% of NAV), like Fund XYZ’s distribution ($4 per share distribution equals 20% of $20 per share NAV).

Most funds post estimates of upcoming distributions on their websites. Alternatively, Mark Wilson’s excellent (and free!) CapGainsValet website tracks estimated fund distributions for just over 300 fund firms (69 of which have posted estimates). The most recent tally had 168 funds with distributions from 10% to 19% of NAV. Wilson’s “doghouse” was populated with 17 funds with distributions of 20% to 29% of NAV and nine funds with distributions exceeding a whopping 30% of NAV.

This could be a great opportunity to take advantage of lower prices and get some of that $20 trillion back, but as we get closer to year-end, it would be wise to check the estimated distribution of the fund you are considering before you buy.•

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Kim is Kirr Marbach & Co.’s chief operating officer and chief compliance officer. He can be reached at 812-376-9444 or mickey@kirrmar.com.